The outlook for currencies

In a world of currency wars and multibillion-dollar quantitative easing programmes, currency hedges are being prescribed as one-way investments in some cases.

Investing in any equity market predicated solely on a currency move is fraught with danger, and if that is the only reason for investing then a moment’s pause is in order. Currency hedging has a binary outcome and can rapidly lead to portfolios becoming unstuck.

European equities have got off to a flying start so far this year as the European Central Bank launched its €60bn (£44.3bn) asset-buying programme, in an attempt to fight deflation and pump liquidity into the eurozone’s underperforming stockmarkets.

As widely expected, that avalanche of money has led to a significant fall in the value of the euro. At the end of May it had dropped almost 10 per cent against the dollar year to date.

Those that hedged the euro to a stronger currency would have made remarkable returns, but there are risks here, especially for relative return strategies.

A relative return fund’s benchmark is unlikely to be hedged, meaning there is much more downside risk than upside. If the call is correct, the outperformance will be added above the benchmark and the manager will be vindicated.

But there is no such thing as a ‘free lunch’, and that extra performance was gleaned at the risk of being wrong. If the currency had gone against the manager, they would underperform their target index by the same margin.

However, it is different for an absolute return strategy, which aims to achieve a certain return regardless of market movements. This way of running money means hedging out a currency is an attempt to de-risk a portfolio.

If the currency moves in the opposite direction, the absolute return manager has only lost the opportunity cost of putting that money to more gainful work elsewhere in the fund.

This is an interesting quirk of risk management. By taking a carte blanche view of a currency across both relative and absolute return strategies and hedging, a manager would be adding risk to one and reducing risk for the other.

The cost of hedging currencies is heavily dependent on relative interest rates, because of the effect of the carry. With developed-market interest rates currently being as low as they are, it is relatively cheap to hedge, which may partly explain its prevalence.

Hedging currencies in an absolute return portfolio can normally be useful for stripping out an ‘unknown’, or taking a call on a currency when the situation demands it.

The launch of European quantitative easing was always likely to depress the value of the euro relative to other currencies, but knowing exactly when the effects will feed through to prices is nigh on impossible.

As is determining how far a currency will fall, and whether outside factors will arrest or even reverse the move. The euro has devalued considerably already – and it may go even lower, or it may not.